Are states threatening to strangle the 529 plan market before it has gotten out of the crib? Fund managers have long talked about states demanding a relatively large cut of the fees from college savings programs, diminishing the possibility for profits among their partners. Now some states are seeking ways to take additional monies from the investors also.

In one sign that of a shift, the state of Washington has quietly dropped plans to start a new plan in partnership with ICMA. The state had tapped ICMA, which specializes in offering retirement plans to state and local government workers, to find a distribution partner for the new plan. However, ICMA reportedly dropped out of the program when it was unable to find any national distributor willing to take up the challenge. The state has no immediate plans to rebid the contract.

ICMA's inability to find a distribution partner likely reflects more than just the bear market. Other providers have told the MFWire.com that the need to split fees between the 529 plan administrators, asset managers and the state sponsors is squeezing profits out of the college savings market. In some ways, the 529 market is starting to look like the high overhead 401(k) market, except that the sponsor is taking a cut too.

At the same time some states are now eyeing the assets in these plans, especially out of state plans held by their residents, as they try to balance their books in a tax-starved environment. If each state puts up barriers to residents trying to purchase out of state plans, the attractiveness of these programs to national distributors will diminish even more.

On April 1, Tennessee said that it would tax the interest and dividends in excess of $2,500 that its residents earn on out-of-state 529 plans. Not only does this diminish the attractiveness out out-of-state plans, it also imposes a burdensome recordkeeping requirement on residents and administrators.

New York is also putting up a wall. The Empire state is planning to punish state residents who switch to another state's plan by taxing the capital gains earned inside the account. It also seeks to make resident pay back taxes on the deductions that they took through the plan. Two more states -- Illinois and Maine -- have cynically decided to impose state income taxes on out-of-state 529 accounts owned by their residents. Maine's tax, which can reach 8.5 percent, was designed specifically to raise revenues during the current downturn and will sunset in three years. Illinois, which taxes income at 3 percent, has no plans to drop the tax it imposed last year.

By erecting these barriers, states are signaling to account holders that out of state plans are fair game for taxation. Sophisticated investors and advisors located in states that are not currently taxing out of state plans have to wonder what the future may hold. Even the potential of taxation will cause some of these investors to prefer an inferior in-state plan to a superior out-of-state plan.

If that happens, 529 plans will not become the nationally distributed product that providers hope they will be. It also ensures that many programs will never achieve the scale to be profitably distributed. Like the plan in Washington, they will wither, or even die.  

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